Do Credit Ratings Really Affect Capital Structure?

• Published date: 01 November 2013
• Author: Ramesh P. Rao,Kristopher J. Kemper
• DOI: http://doi.org/10.1111/fire.12016
• Date: 01 November 2013

The Financial Review 48 (2013) 573–595

Do Credit Ratings Really Affect Capital

Structure?

Kristopher J. Kemper∗

Ball State University

Ramesh P. Rao

Oklahoma State University

Abstract

This paper revisits recent investigations into the role credit ratings play in the marginal

financing behaviorof firms. Although it has long been documented that credit ratings may be an

important determinant of firm capital structure policy,academics have only recently subjected

this motivation to empirical scrutiny.We add to the brief existing literature by investigatingthe

sensitivity of marginal financing behaviorof firms to a number of attributes deemed to capture

firms’ affinity to emphasize credit ratings in their financing behavior. Our results suggest that

credit ratings are not a first-order concern in capital structure decisions.

Keywords: capital s tructure,credit ratings

JEL Classifications: G24, G32

1. Introduction

Until recently, the effect of credit ratings on capital structure had not been

formally investigated. The motivationfor the recent interest in this topic can be traced

∗Corresponding author: Department of Finance and Insurance, Miller College of Business, Ball State

University,Muncie, IN 47306; Phone: 765-285-2198; Fax: 765-285-4314; E-mail: kjkemper@bsu.edu.

C2013 The Eastern Finance Association 573

574 K. J. Kemper and R. P. Rao/The Financial Review 48 (2013) 573–595

to Graham and Harvey’s (2001) survey paper that lists maintaining a credit rating as

the second most important objective in a firm’s credit policy. Kisgen (2006, 2009)

finds the credit rating-capital structure (CR-CS) model (i.e., firm capital structure

policy is influenced by credit ratings) to be generally descriptiveof how firms behave.

We argue that the CR-CS motivation is more applicable to a subset of firms than to

all firms generally.At a minimum, even assuming CR-CS applies to the average firm,

we expect that its appeal will vary systematically across firms classified by certain

firm-level attributes. We examine several attributes. First, we test the sensitivity to

firms that are active,or likely to be active, capital market participants versusfirms that

are less active in capital markets. Second, we examine the sensitivity of the CR-CS

model to the bond rating of the firm. That is, is an AA rated firm more motivated to

take capital structure actions to maintain its rating than an A rated firm? Also, is a firm

that is on the cusp of the investment/noninvestment grade rating more motivated by

CR-CS considerations than other firms? Third, we test the sensitivity of the CR-CS

motivation to firms that are activein the commercial paper market compared to firms

that are not. Last, we examine the capital structure behavior of firms as it relates

to the investment opportunities available to these firms. We argue that firms with

greater growth opportunities would be more likely to be concerned with maintaining

or achieving a long-term rating. The foundation for this argument is that these firms

are likely to be raising capital in the near future and would be interested in doing so

at the lowest possible cost.

We reconfirmKisgen’s (2006) findings that firms at the edge of a ratings change

have a propensity to use less debt at the margin, thus supporting the CR-CS model.

However, we are unable to document that the CR-CS motivation is systematically

related to any of the attributes listed above, which we argued should proxy for

management’s inclination to adopt the CR-CS model. Especially damaging is the

fact that the CR-CS model does not appear to hold across all rating classes. In fact,

our analysis indicates that with the exception of B rated firms, firms in no other rating

group seem to curtail debt financing when faced with the prospect of losing its rating.

Thus, Kisgen’s (2006) original findingsappear tobe driven by the subsample of firms

with extremely low ratings. This is weak evidence in support of the CR-CS model,

especially given that B rated firms are generally associated with financial distress.

Therefore, their marginal financing behavior to avoiddebt may be more an indication

of lack of access to the debt market than an indication of a conscious attempt to

decrease debt financing. Additionally, the CR-CS model implies that firms on the

cusp of the investment and noninvestmentgrade rating should be especially sensitive

to the impact of their marginal financing behavior on their credit ratings. However,

our results do not find this to be the case. Withregard to the other attributes, our results

are just as puzzling. We do not findthat the CR-CS model is more applicable to firms

that have external financing needs and firmsthat regularly access the capital markets,

firms that access the commercial paper market, and high-growth firms. These results

lead us to conclude that the CR-CS model is not a good descriptor of how firms

determine their marginal financing decision. Weare careful to point out that this does